This year’s annual report examines a project the Fed is spearheading to improve the U.S. payment system. The essay is written by St. Louis Fed First Vice President David Sapenaro, who recently completed his responsibilities as the project’s interim payments strategy director.

The Econ Lowdown e-newsletter is the most convenient way for economics and personal finance teachers to stay up-to-date on the latest videos, podcasts, curriculum, classroom activities and events from the St. Louis Fed.

U.S. Income Inequality: It's Not So Bad

Thomas A. Garrett

Each year, the U.S. Census Bureau releases data on the income levels of America’s households. A comparison of the annual data over time reveals that the income of wealthier households has been growing faster than the income of poorer households - the real income of the wealthiest 5 percent of households rose by 14 percent between 1996 and 2006, while the income of the poorest 20 percent of households rose by just 6 percent.

As a result of these differences in income growth, the income of the wealthiest 5 percent of households grew from 8.1 times that of the income of the poorest 20 percent of households in 1996 to 8.7 times as great by 2006. Such figures commonly lead to the conclusion that income inequality in the United States has increased. This apparent increase in income inequality has not escaped the attention of policy makers and social activists who support public policies aimed at reducing income inequality. However, the common measures of income inequality that are derived from the census statistics exaggerate the degree of income inequality in the United States in several ways. Furthermore, although many people consider income inequality a social ill, it is important to understand that income inequality has many economic benefits and is the result of - and not a detriment to - a well-functioning economy.

An Inaccurate Picture

The Census Bureau essentially ranks all households by household income and then divides this distribution of households into quintiles. The highest-ranked household in each quintile provides the upper income limit for each quintile. Comparing changes in these upper income limits over time for different quintiles reveals that the income of wealthier households has been growing faster than the income of poorer households, thus giving the impression of an increasing “income gap” or “shrinking middle class.”

One big problem with inferring income inequality from the census income statistics is that the census statistics provide only a snapshot of income distribution in the U.S., at a single point in time. The statistics do not reflect the reality that income for many households changes over time - i.e., incomes are mobile. For most people, income increases over time as they move from their first, low-paying job in high school to a better-paying job later in their lives. Also, some people lose income over time because of business-cycle contractions, demotions, career changes, retirement, etc. The implication of changing individual incomes is that individual households do not remain in the same income quintiles over time. Thus, comparing different income quintiles over time is like comparing apples to oranges, because it means comparing incomes of different people at different stages in their earnings profile.

The U.S. Treasury released a study in November 2007 that examined income mobility in the U.S. from 1996 to 2005. Using data from individual tax returns, the study documented the movement of households along the distribution of real income over the 10-year period. As shown in Figure 1A, the study found that nearly 58 percent of the households that were in the lowest income quintile (the lowest 20 percent) in 1996 moved to a higher income quintile by 2005. Similarly, nearly 50 percent of the households in the second-lowest quintile in 1996 moved to a higher income quintile by 2005. Even a significant number of households in the third- and fourth-lowest income quintiles in 1996 moved to a higher quintile in 2005.

The Treasury study also documented falls in household income between 1996 and 2005. This is most interesting when considering the richest households. As shown in Figure 1B, more than 57 percent of the richest 1 percent of households in 1996 fell out of that category by 2005. Similarly, more than 45 percent of the households that ranked in the top 5 percent of income in 1996 fell out of that category by 2005.

Thus it is clear that over time, a significant number of households move to higher positions along the income distribution, and a significant number move to lower positions along the income distribution. Common reference to “classes” of people (e.g., the lowest 20 percent or the richest 10 percent) is quite misleading because income classes do not contain the same households and people over time.

Another problem with drawing inferences from the census statistics is that the statistics do not include the noncash resources received by lower-income households - resources transferred to the households - and the tax payments made by wealthier households to fund these transfers. Lower-income households annually receive tens of billions of dollars in subsidies for housing, food and medical care. None of these are considered income by the Census Bureau. Thus the resources available to lower-income households are actually greater than is suggested by the income of those households as reported in the census data.

At the same time, these noncash payments to lower-income households are funded with taxpayer dollars - mostly from wealthier households, since they pay a majority of overall taxes. One research report estimates that the share of total income earned by the lowest income quintile increases roughly 50 percent - whereas the share of total income earned by the highest income quintile drops roughly 7 percent - when transfer payments and taxes are considered.

The census statistics also do not account for the fact that the households in each quintile contain different numbers of people; it is differences in income across people, rather than differences in income by household, that provide a clearer measure of inequality. Lower-income households tend to consist of single people with low earnings, whereas higher-income households tend to include married couples with multiple earners. The fact that lower-income households have fewer people than higher-income households skews the income distribution by person. When considering household size along with transfers received and taxes paid, the income share of the lowest quintile nearly triples and the income share of the highest quintile falls by 25 percent.

Is Policy Needed?

Income inequality will still exist even if the income inequality statistics are adjusted to account for the aforementioned factors. Given the negative attention income inequality receives in the media, it is important to ask whether reducing income inequality is a worthy goal of public policy. It is important to understand that income inequality is a byproduct of a well-functioning capitalist economy. Individuals’ earnings are directly related to their productivity. Wealthy people are not wealthy because they have more money; it is because they have greater productivity. Different incomes reflect different productivity levels.

The unconstrained opportunity for individuals to create value for society - and the fact that their income reflects the value they create - encourages innovation and entrepreneurship. Economic research has documented a positive correlation between entrepreneurship/innovation and overall economic growth. A wary eye should be cast on policies that aim to shrink the income distribution by redistributing income from the more productive to the less productive simply for the sake of “fairness.” Redistribution of wealth increases the costs of entrepreneurship and innovation, with the result being lower overall economic growth for everyone.

Poverty and income inequality are related, but only the former deserves a policy-based response. Sound economic policy to reduce poverty would lift people out of poverty (increase their productivity) while not reducing the well-being of wealthier individuals. Tools to implement such a policy include investments in education and job training.

Income inequality should not be vilified, and public policy should encourage people to move up the income distribution and not penalize them for having already done so.

Figure 1A. Movement to Higher Income Quintiles

1996-2005

Figure 1B. Movement to Lower Income Group

1996-2005

SOURCE: Treasury Department

One problem with popular portrayals of the income gap is that they show income distribution at a single point in time. But for many households, income changes over time. The low-paying jobs from high school days usually give way to better-paying jobs later in life. Figure 1A shows the percentage of households that moved to a higher income quintile from 1996 to 2005. For example, nearly 58 percent of the households in the lowest income quintile in 1996 moved to a higher category by 2005. The reverse also happens, as shown in Figure 1B. Of those households that were in the top 1 percent in income in 1996, for example, more than 57 percent dropped to a lower income group by 2005.

Glossary

Adjusted gross income — Total income less statutory adjustments.

Business cycle — The periodic but irregular up-and-down movements in economic activity, measured by fluctuations in real GDP and other macroeconomic variables.

Capitalism — Economic system characterized by the following: ownership of private property; individuals and companies that are allowed to compete for their own economic gain; and free-market forces that determine the prices of goods and services.

Income — Earnings received as wages, rent, profit or interest; payments received for providing natural, human capital and entrepreneurial resources in the market.

Inflation — A sustained increase in the average price level.

Poverty — A condition that occurs when people do not enjoy a certain minimum level of living standards, as determined by a government.

Productivity — A ratio of output to input during a specified period of time. For example, output per worker is a measure of the productivity of labor during an hour, week, month or year. The productivity of workers can be increased through division of labor, investment in human capital and investment in capital resources.

Purchasing power — A measurement of the relative value of money in terms of the quality and quantity of goods and services it can buy.

Quintile — One of five equal parts of a range of data, each being 1/5th (20 percent) of the range.

Real income — Income expressed in terms of the goods and services it can purchase.

Standard of living — A measure of the goods and services available to a person in a country; the dollar value is calculated as per capita GDP.

Subsidies — Financial assistance given by the government to individuals or groups.

Taxes — Mandatory government fees on business and individual income, activities or products.

Taxable income — Adjusted gross income less standardized or itemized deductions.

Transfer payments — Payments by governments - such as social security, veterans’ benefits and welfare - to people who do not supply goods, services or labor in exchange for the payments.

Wealth — Accumulated assets such as money and/or possessions, often accumulated as a result of saving and investment.